Former New York Fed President Dudley pointed out on Friday that although Federal Reserve Chairman Powell has been trying to avoid discussing the impact of Trump 2.0 on its policy outlook, he will soon have to confront this issue directly. The full text is as follows.

When Powell faces the media after next week's central bank decision meeting, he may encounter a politically concerning question: How will the Federal Reserve incorporate the plans of incoming President Trump (including tax cuts, tariffs, and the expulsion of illegal immigrants) into its economic outlook and monetary policy?

In November of this year, Powell's response was firm: "We do not guess, we do not speculate, we do not assume." But this time, he must answer in more detail.

In fact, the Federal Reserve can and sometimes must make assumptions about the actions of politicians. As early as December 2016, when I served as vice-chair of the Federal Open Market Committee (FOMC) and Trump had just won his first term, staff's forecast assumed that "Congress will pass a personal income tax reduction plan equivalent to 1% of GDP, starting in the third quarter of next year."

At that time, I asked the staff a question similar to what Powell might face: "What is the threshold for the Federal Reserve to take action in response to enhanced trade barriers or tightened immigration policies?" Based on the answer at that time and my experience at the Federal Reserve, I believe there are four criteria.

First, the likelihood of a policy shift must be significant.

Secondly, this shift must be significant enough to have a meaningful impact on economic growth, employment, inflation, or financial conditions (including stock prices and interest rates).

Third, the Federal Reserve needs to clarify the content of the policy. In December 2016, potential tariffs were not included in the forecast. As Steve Kamin, then head of the Federal Reserve's International Finance Division, said, the various possibilities are "vastly different" and their magnitude is "difficult to measure," so the Federal Reserve staff "chose not to make assumptions."

Fourth, if the stock and bond markets have already begun to anticipate a policy shift, then the Federal Reserve will find it difficult to ignore. This is one of the reasons tax cuts were included in the December 2016 forecast. At that time, David Wilcox, who was head of the Federal Reserve's Research and Statistics Division, stated, "It was clear that financial market participants had made a judgment that something might happen," and excluding these expectations from the forecast would be an overly cumbersome and "complex process."

So, how will Powell act? I believe he will follow the approach of 2016. He will say that the Federal Reserve expects the tax cuts in 2017 to be extended and has incorporated that into its forecast— but has not yet made any adjustments based on tariffs or the expulsion of illegal immigrants. Including the extension of tax cuts in the forecast is reasonable, as it is highly likely to happen and is large in scale. In contrast, trade and immigration policies remain too uncertain, just like in 2016.

Powell is unable to explain how these will affect the FOMC's Summary of Economic Projections (SEP), as committee members are not bound by staff assumptions. That is to say, I expect they will largely follow the staff, only incorporating the continuation of current tax cuts. Therefore, their forecasts will be optimistic and will not form a pessimistic outlook on economic growth, inflation, productivity, or labor supply due to tax increases, tariffs, or the expulsion of illegal immigrants.

Specifically, I expect the median projections for the economic outlook in 2025 and 2026 in the updated SEP in December to be slightly stronger than in September, reflecting the ongoing momentum in the economy and a higher trend in productivity growth. The unemployment rate will still be slightly above the level that Federal Reserve officials believe is consistent with stable inflation. The inflation rate will decline to the Federal Reserve's target of 2%, most likely reaching it in 2026. By 2026 or 2027, the federal funds rate will drop to the neutral level that the Federal Reserve believes is consistent with a 2% inflation rate. This path may only involve a rate cut of 50 to 75 basis points in 2025 (compared to the 100 basis points forecast in September). The neutral rate may rise slightly, to 3% or higher, but will be far below the level currently implied by futures prices.

The Federal Reserve's baseline expectation will be the same as in September: that as the labor market loosens and inflation recedes, monetary policy will gradually shift from restrictive to neutral, and the U.S. economy may achieve a soft landing. When the tariffs and immigration policies of the Trump administration come into focus, the outlook may become less optimistic.

Article forwarded from: Jin Shi Data